It's the European Union, not the United States, that is
China's largest trade partner. The Sino-EU trade balance is just as
unbalanced as the Sino-US one, even though the latter might have been more
politicised.

In 2006, China's exports to EU reached US$181.98 billion, a rise of
26.6 percent year-on-year, according to the Chinese Ministry of Commerce.
Imports from the EU totalled US$90.32 billion, an increase of 22.7 percent
from the previous year. [1]

Euro and Yuan

The gap between exports and imports is stunning. In 2006, it was US$91
billion, with China exporting twice as much to Europe as it imported from
there. For 2007, the trade gap is likely to widen to US$235 billion (Euro
160 billion).[2]

Clearly, this is not a sustainable situation. This is not to say that
bilateral trade between countries must always be balanced, but when such
huge amounts are involved, any imbalance must be extremely difficult to
make up from trade with other countries.

Huge foreign reserves

Years of trade surpluses have led to the Chinese holding a lot of US
Treasury Bonds among its US$1.3 trillion worth of foreign reserves. China
has been among the top buyers for years, though market observers have
noted a trend starting in the middle of this year with the Chinese scaling
back their purchases.

That should hardly come as a surprise. The falling US Dollar
has made it
rather silly to keep one's foreign reserves in that currency, yet by being
among the largest holders of US Treasury debt, it was impossible for China
to get out of it in any significant way without causing a stampede.
Untying this knotty problem is going to take many years, and even then,
the chances of doing so smoothly aren't bright.

If China is seen to be abandoning the US Dollar, the latter currency
will go into a free fall. Americans will find imports prohibitively
expensive and the economy will stutter. This will have knock-on effects on
plenty of manufacturers and service providers around the world who depend
on selling to the American market, including the Chinese ones. An American
recession will ripple across the globe.

It is likely also to severely undermine banks. As the problem in the
subprime mortgage market is showing, many banks around the world hold US
Dollar-denominated assets. As these are written down, banks can be
severely weakened leading to banking and liquidity crises.

Yet if the Chinese do not do something about their vast holdings of US
Treasury debt, the steady decline of that currency must surely erode the
value of China's foreign reserves.

I wonder if history's verdict might be that the Chinese were foolish to
rake in so much in trade surpluses. History has already judged the
Americans, courtesy of the Bush administration, foolish in running up such
a huge current account deficit -- it was a record US$857 billion in 2006.
[3]

Yet what else could the Chinese have done? Beijing needed to lift the
country out of poverty, the world was knocking on Chinese manufacturers'
doors, so why not export as much as possible?

China needs a bigger domestic growth engine

The bias towards export-led growth has a historical explanation. It
made sense when foreign investment and foreign exchange was badly needed
in the early days of China's opening up. Foreigners had the funds and the
technological know how, and Western countries were the most attractive
markets. The 1980s' Special Economic Zones (SEZ) that Deng Xiaoping promoted to
attract such investments made sense.

But at some point, the line was crossed when China started making far
more in foreign trade surpluses than it knew what to do with. In a
metaphorical sense, the whole Eastern seaboard is now one big SEZ. These
surpluses had to be parked abroad; repatriating them into Yuan would cause
uncontrollable domestic inflation since China does not have a true
floating exchange rate.

By this stage, China should
not still be so reliant on export-led
growth. The countless multitude of small manufacturers would surely be
happy to sell to whoever would buy, including domestic customers. The
problem may be that China has been too slow to free up its domestic
market. Administrative obstacles, corruption, poor infrastructure and an
unresponsive banking system make it more difficult for domestic producers
to target the domestic market than should be.

While things are improving and China's economy now has a strong
domestic engine, nevertheless an uncomfortably large part, especially
employment, is dependent on export demand. This means the Yuan cannot be
delinked from the US Dollar anytime soon, yet without a significant revaluation
of the Yuan, it means the Sino-US trade imbalance will continue.

But what to do with the profits?

I suppose, theoretically, rather than letting the foreign exchange
surpluses pile up, China should have used them to improve its own economy
and the living standards of its people. The government could have been
more aggressive in buying improvements to ports, railways,
telecommunications, and investing too in education, healthcare and
housing. However, I concede I cannot quite imagine how one can use foreign
exchange to improve education and healthcare domestically -- surely these
are highly dependent on trained local human resources. I would also add
that China could have invested heavily in energy efficiency and
environmental protection, including research into these fields. These 2
areas must be tackled before they become major impediments to further
growth soon.

China's
construction boom never lets up

No doubt, all the above is easier said than done. Carrying out such
ambitious designs requires technical and management capabilities that
China's political class may not have. In any case, there are already
severe bottlenecks from an overheated economy, growing at 11 percent a
year; adding more projects will only make things worse. Already, China's
inflation rate is in the region of 6.5 percent this year.

But continuing on this path is also untenable. The Europeans are going
to get angry; the Americans still aren't mollified despite their devaluing
Dollar (because the Yuan more or less follows it down).

Revaluation

To be a responsible partner in the world economy, the Chinese need to
do a serious rethink of their role in it. They are well past the point
where accumulating more foreign reserves through export-led growth will do
them any good.

They have to contemplate a steady revaluation of the Yuan. No doubt
this causes Chinese central bankers sleepless nights. I suspect the
problem lies in the fact that there are two Chinas. The coastal regions,
with better developed markets and companies able to invest in technology
to improve productivity may be able to absorb a gradual currency
revaluation, but the hinterlands are still very poor. There is a lot of
underemployment, poor infrastructure and low technology, and it would be a
cruel outcome if China's export and wealth-creating engine is jeopardised by
a revaluation before development has trickled into the inland provinces.

Perhaps some mild revaluation may be able to finesse the difference,
though even then, there will be some degree of employment losses as export
manufacturers become less competitive

Tax changes can help induce the manufacturers to relocate inland where
labour is still cheap even with a revalued Yuan, though massive
improvements in transport infrastructure will be needed to ship the goods
out efficiently. The unemployment risk can also be addressed by focussing
on the services sector. For one thing, China needs a massive expansion and
upgrade of the now-collapsing national healthcare system.

At the same time, the government must do a lot more for education, for
there is no social time bomb more dangerous than a people shut out of a
modernising economy because of poor education, yet see others get rich.

Sovereign wealth fund

Those reserves the country already has (and will no doubt continue to
acquire) need to be put to better use before they lose their value.
Earlier this year, China set up its sovereign wealth fund with the aim of
taking up stakes in companies with good returns. Its seed money alone is
reported to be a whopping US$300 billion.

Sooner or later, given the way the Americans tend to see China as a
strategic threat, the US Congress will get hysterical about an intended
purchase, especially if an iconic company with cutting edge technology or
dominant position in the American market is involved. Congress' tendency
needs to be reined in, otherwise more conflict will occur.

The fact is, after 2 decades of fast-paced growth, China is coming into
its own as a middle-income economic power and a major player in the world
economy. A strategic realignment of economic power is called for, which
must be hard for the US to stomach. Yet, whether through revaluation of
the Yuan (the US' preferred solution) or fast accumulating surpluses from
a cheap Yuan (possibly China's preferred solution), China will have huge
buying power. The US and the EU cannot frustrate that new reality and
still expect all to be well.